The Stock Market Is Sending Three Bearish Messages

The stock market is a leading economic indicator with an impressive track record. And that’s exactly how I am interpreting three recent developments and why I want to warn you about them today:

Bearish Message #1 —
The Banking Sector
Showing Negative Divergence

The concept of uniformity and divergences is one of the most important technical tools. Strong trends are characterized by a high degree of uniformity. During a healthy bull market more or less all sectors are participating in the rise. And during a strong bear market most everything is falling.

When trends grow old and weak this picture starts to change. Suddenly, during an old bull market the tide isn’t lifting all boats in spite of all the good news that may still be coming out. And at the end of a bear market some sectors stop declining while bad news captures the media.

According to this concept the cyclical rally that started in March 2009 has finally entered its last inning, the topping process. Why? Because more negative divergences are showing up. The most far reaching is coming from the important banking sector.

As you can see on the following chart the Philadelphia Bank Index made its high for the current cycle in April 2010. When the S&P 500 made new highs this February, the Bank Index also rose, but it lost steam from its 2010 high. And since mid-February until the end of May, the BKX has slid more than 12 percent.

Banks have been the worst performing sector year to date. And the chart pattern looks like a huge topping formation with a slightly rising neckline currently around $45. It has not been broken yet, but it’s definitely an ominous looking pattern,

But there is even more to say about the financial sector’s weakness …

During the past three months when bank stocks staged double-digit losses, 10-year Treasury yields declined roughly 60 basis points. This is a rare combination. And when it occurs its implications are very bearish. Historically this combination has been a harbinger of a recession as in 1990, 2000, and 2007 … or of a crisis as in 1998 and 2002 … or both.

Bearish Message #2 —
A Failed Breakout of the S&P 500
and a Broken Uptrend Line

At the end of April the S&P 500, most other U.S. indices and a few international indices like the German DAX rose to new highs for the year and thus for the cyclical bull market. At first glance this looked like a bullish breakout. But the market was already stretched, volume was low, and sentiment much too high. Therefore I was very skeptical.

Now, about four weeks later, all of these indices are clearly back below their respective breakout lines, meaning that the latest breakout attempt has obviously failed.

During a healthy bull market a breakout has enough follow through buying to keep the market rising. If this is not the case, the market is telling us that a potentially important change in character has taken place, from bull to bear.

A failed breakout is as important a technical signal as a successful one. The latter points towards a continuation of the bull move. But the former indicates severe weakness. It has to be seen as a clear warning sign that the bull market is in jeopardy.

Additionally the S&P 500 has broken its uptrend line, which began in late August when Ben Bernanke announced the implementation of QE2. This break is just another sign of weakness.

Obviously, the technical situation of the stock market has deteriorated markedly. The price momentum oscillator (PMO) is still in neutral territory, leaving lots of room for further short-term downside movement. And longer term momentum indicators exhibit important negative divergences as well. Thus they, too, are signaling a major top in the making.

S&P 500, Momentum Indicator, Volume, 2010 — 2011

Bearish Message #3 —
Emerging Markets
Are Looking Weak

As I wrote in my Money and Markets column two weeks ago, there are far reaching negative divergences on a global scale. Most emerging markets stock market indices saw their cyclical highs last November. Their charts are not only showing clear relative weakness, but well-formed potential topping formations have also developed.

Emerging markets were first to bottom out during the last bear market. And now they may again be ahead and leading the way into the next global bear market.

My recommendation: This is not the time to be in stocks. The market is at least 40 percent overvalued and the macroeconomic picture is deteriorating quickly.

And to profit from downside moves, you might consider an inverse ETF of a broad index like the S&P 500 or the Nasdaq. Two examples are ProShares Short S&P 500 ETF (symbol SH) and ProShares Short QQQ ETF (symbol PSQ). Try to get the former for around $40.80 and set a stop loss at $38.80. If you want the latter, shoot for $32.50 with a stop loss of $31.

Best wishes,

Claus